Deflating Inflation

December 7, 2003 • Commentary
This article was published in The Washington Times, Dec. 7, 2003.

“Some fear inflation is ready for a comeback,” or so says the headline of a Wall Street Journal story by Ken Brown. Only six months ago, I felt obliged to debunk deflation scares then in vogue. Now we are suddenly being urged to worry about inflation. Do things really change that quickly, or do journalists just have to keep discovering something new for us to worry about?

As with the deflation scare earlier this year, the inflation stories in the popular press don’t hold up too well on close examination. The Wall Street Journal’s version mainly relies on veiled theories about inflation. A table of statistics includes only the lowest measure of inflation, the core Consumer Price Index. And any figure about past inflation tells us little about the future. Inflation is always lower before it moves higher. Other numbers in the table would be informative only if some theory could link them to inflation.

One theory relies on a syllogism: “If the Federal Reserve shares that view [about a strong economy being inflationary], it will push up the federal funds rate, which… could slow or stop the recent economic rebound.” The first premise is that strong economic growth boosts interest rates. The secondary premise is that higher interest rates weaken economic growth. Accept both premises, and your conclusion must be that strong economic growth causes weak economic growth.

To avoid that paradox, scrap the second premise. Real interest rates always move higher when real gross domestic product speeds up, and rates decline in recessions. Real interest rates are what is left after subtracting inflation, so it is wrong to treat every interest rate rise as evidence of inflation.

Mr. Brown says: “If the Fed starts to jack up interest rates… [investors] will sell stocks. That’s because with interest rates higher, stocks will look less attractive.” Less attractive than what? Not less attractive than bonds. If interest rates move higher because a strong economy creates more profitable business opportunities, the rise in earnings will far outweigh any decline in the ratio of stock prices to earnings. The economy often moves the Fed, rather than the other way around.

A bond trader is quoting fearing a 2½ percent fed funds rate by the end of 2005. I’m sure the fed funds rate will be higher than that next year, but that is right and good. If the Fed tried to keep the interest rate on bank reserves below 2 percent during a time of vigorous economic activity, it would have to buy gobs of Treasury bills and create new bank reserves to pay for them. Judging by past behavior, the Fed is likelier to slowly adjust the fed funds rate to keep pace with the year‐​to‐​year trend of spending — nominal GDP — which is already above 5 percent.

Mr. Brown says, “A period of weak growth, which would keep inflation in check, is possible.” If the economy is strong, we will get higher inflation and interest rates — and end up with a weak economy. If the economy is weak, we start with a weak economy. Either way, the economy can only be weak. This theory cannot even begin to explain how China mixes real economic growth of 9 percent with inflation of 1.8 percent. The article mentions some facts: “So far, the market has shrugged off the declining dollar, rising commodity prices and big budget and trade deficits because the jobs market, until recently, was so weak.” The idea the stock market “shrugged off” warnings of inflation presumes the market goes down if inflation goes up. Ironically, the Economist was apoplectic in urging the Fed to tighten in the late ‘90s because stock prices were soaring. But stocks do suffer with serious inflation, which means inflation risk was low in the ‘90s and is still low today.

The broad dollar index was around 116 in late 1999 when the Fed started raising interest rates, rose before and during the recession, and was back down to about 116 by late November. Whether the dollar is up, down or sideways depends on where you start. In any case, the post‐​recession decline of the dollar is relevant only to the extent it might have inflated import prices. In October, the yearly increase in import prices was only 0.9 percent, and even lower without oil.

Prices of industrial commodities are cyclical, so they bounced back with global economic recovery. In Europe and Japan, unlike China, the lower dollar has made commodities like oil and copper cheaper in terms of euros and yen.

To the extent the dollar’s drop is not expected to last, it would pay European and Japanese to stockpile oil and other commodities priced in dollars. If China feels pressured to revalue the yuan, that too would foster stockpiling and result in higher commodity costs for U.S. industry. But stockpiling is a temporary phenomenon, and one‐​time price changes should not be called inflation.

Gold is different, because it is held mainly as an asset. If people are converting greenbacks to gold as a hedge against inflation, however, I would expect more speculation in the futures market. The last I looked, you could buy gold a year from now for only 1½ percent more than today’s price. That is a very low interest rate for holding gold.

The “big budget and trade deficits” are red herrings. If big budget deficits were inflationary, Japan would be suffering hyperinflation. As for trade deficit, cheap imports are certainly not boosting the cost of living, but restricting them would.

That leaves wages. “Most experts,” writes Mr. Brown, “the Fed included, believe the economy would need to create hundreds of thousand of jobs — as many as 150,000 to 200,000 a month for the better part of a year — for any inflationary pressure to rise.” I don’t know how he could know what most experts believe, but that is not it. Inflation happens when the Fed supplies more dollars than people feel secure about holding, so they offer more and more dollars for fewer and fewer goods. If we needed low unemployment to have high inflation, then the horrible stagflations of the ‘70s could never have happened.

The reason labor costs are down and profits are up is not because unemployment kept pay down but because of efficiency and economic recovery. Between the third quarters of 2002 and 2003, compensation in U.S. manufacturing industries rose 4.4 percent, yet labor costs did not rise — because output per hour rose 4.4 percent.

There may be good reasons to be concerned about inflation in the years ahead, but much of what I have seen about this topic so far appears to be based on questionable theories and unpersuasive facts. Inflation is always worth watching, and certainly worth preventing with sensible Fed policy. But if worry is the actual objective, there must be things to worry about.

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